The front page of the Wall Street Journal today is chock a block with good stories, so you're getting posts on all of them.
Lehman reports a big loss, tries to raise money Just when you thought it was safe to go back in the markets.
Lehman's larger-than-expected loss was accompanied, as anticipated, by word that the firm will seek to raise $6 billion in fresh capital. On Wall Street, the loss underscored the challenges Lehman and its rivals must face as they dramatically reduce their reliance on borrowed money. The use of debt, which helped fuel record profits when markets were booming but also led to excessive risk-taking, has come back to haunt them.As Lehman and other securities firms now curtail their use of borrowed cash, it will be much harder for them to generate the kind of profit growth investors had become accustomed to.
This inevitably puts me in mind of a wonderful passage from John Kenneth Galbraith's A Short History of Financial Euphoria, which I highly recommend, if for no other reason than the amusing stories. Galbraith notes:
Uniformly in all such events, there is the thought that there is something new in the world. It can be, as we shall see, one of many things. In 17th-century Europe it was the arrival of tulips in Western Europe . . . later, it was the seeming wonders of the joint stock company, now known as the corporation. More recently, in the United States, prior to the Great Crash of 1987 (often referred to more benignly as a meltdown) it was the accomodation of markets to the confident, free-market vision of Ronald Reagan with the companion release of the economy from the heavy hand of government and the associated taxes, antitrust enforcement, and regulation. Contributing was the rediscovery, as reliably as before, of leverage . . .As to new financial innovation, however, experience establishes a firm rule, and on few economic matters is understanding more important, or frequently, more slight. The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt, secured to a greater or lesser adequacy by real assets. This was true of one of the earliest seeming marvels: when banks discovered that they could print bank notes and issue them to borrowers in excess of the hard-money deposits in the banks' strong rooms. There was no seeming limit to the amount of the debt that could thus be leveraged on a given volume of hard cash. A wonderful thing. The limit became apparent, however, when some alarming news, perhaps the extent of the leverage itself, caused too many of the original depositors to want their money at the same time. All subsequent financial innovation has involved similar debt creation leveraged against more limited assets with only modifications in earlier design. All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.
This is, as is often true of Galbraith, slightly too pat. But there's a pretty deep truth in his assessment.
So who else first read this as "Give me a big enough lover..."?
Showing some love for John Kenneth Galbraith? When did you become a DFH?
I'm enjoying the 20th century economist tour here at the blog. Looking forward to tomorrow's installment - will it be Coase? Arrow? a Pigou pigout?
As so often, it is worth analysing the way in which Galbraith is too pat. There are five formulas in this world for getting rich quick:
1. Get incredibly lucky, like win the lottery.
2. Steal the money - as legally as is convenient.
3. Do something really useful - like produce a model T or Windows.
4. Persuade people to buy something that is of little value.
5. Persuade someone to lend you money cheaper than you can lend it on.
Methods 1 to 3 are intrinsically hard to copy.
Method 4 involves having something to sell that people have no reliable means of valuing. It becomes posssible and easy only when an easily multipliable such good appears. This method of trying to get rich quick is what produces tulip, South Sea and dot.com bubbles. These are bubbles based on ignorance and hope, not on debt; even though debt allows their exaggeration.
Method 5 variations are intrinsically easy to copy, and easily multipliable. They are all based upon debt. They are the favourites of those who "sincerely want to become rich" because of these characteristics. By the same tokens, they are the field the financial regulator seeks to control; the principal source of debt crises; what Warren Buffet calls weapons of mass financial destruction; and methods where applying levers results in shaking the world.
So what Galbraith skated over is that financial operations do lend themselves easily to apparent innovation, and that tulip-type crises are not founded on creation of debt. Further, he ignored (I suspect for reasons of melifluency) the undoubted fact that some innovations in financial operations - e.g. banking, futures - do something really useful.
The deep truths he put over so eloquently are that new variations of method 5 are always just that and no more; and that leverage is a perpetual temptation and danger to the financial world.
You should have used the words "fractional reserve banking" and "Ron Paul" in this post to spice up the comment section.
The problem with Galbraith's analysis is that today's normal, traditional financial instrument was invariably yesterday's innovation. Yes, there were manias and euphorias that led to dislocations, but the fundamental soundness of the innovations plays out over and over again. Weren't high yield bonds written off by the likes of Mr. Galbraith with the collapse of Drexel. How big was the market then? How big is it now? Emerging market debt?
diversity - I'd put in one more way to get quick. Buy low and sell high. That can mean running a grocery store or it can mean buying 1000 shares of stock when you know someone just put in an order to buy 1,000,000 and selling right afterwards.